Preferred Equity Basics Part 1
There Is A Reason Why Preferred Equity is Called Preferred:
Preferred Equity Has a Big Impact on the Value of Common Stock
The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for 409A compliance. But more importantly, they determine the amount of money employees may receive when the long hoped-for “exit” is finally realized.
This is the first in a series of posts meant to help explain many of the typical forms of preferred equity we see. We will provide guidance on the impact to the holders of common shares.
Preferred equity is extremely malleable, the specific terms and conditions are tailored to the facts and circumstances of each unique case. So there can be additional differences between the cases discussed here and the specific equity structure of any particular company.
Overview of Preferred Equity
Preferred equity is sometimes described as a hybrid security that combines elements of a debt security and an equity security. To the extent that the preferred equity provides for the return of principal and commits to the payment of dividends (in effect the dividend acts like an interest payment), it is similar to debt. To the extent that there may be no specific time-frame for when the original amount invested must be repaid and it participates in the growth of the company, it is similar to equity.
Venture Capital Preferred Equity is Different
In venture capital financings, the debt-like characteristics of preferred equity are changed and significantly expanded. While often there is no mandatory dividend, there are hosts of additional rights, protections, and privileges. Preferred equity issued to a venture capital firm is a highly customized security that provides the preferred investor a set of provisions (“preferences”) that are tailored to each company’s unique requirements and circumstances. Preferred stock rights often grant the preferred stockholder advantages relative to the common stockholder. The preferred equityholders may have some or all of the following rights:
o To earn a return on their investment that is disproportionate to the percentage of shares owned relative to the common,
o Downside protection, and
o To have disproportionate influence or control over the company.
Economic Rights and Control Rights
Using the terminology of the AICPA, certain provisions give the preferred equityholder economic rights and control rights: “…preferred stock has characteristics that allow preferred stockholders to exercise various economic and control rights”.
o Preferred Dividends – As discussed above, mandatory dividends are infrequent in the venture capital transactions we have observed. However, specific dividend rights may be granted.
o Liquidation Distributions – These rights are critical to understanding the value of common shares. These rights refer to the specific rules by which the proceeds from a sale of the company are distributed among each class of shareholders.
o Mandatory Redemption Rights – These rights give a class of preferred equity the ability to require the company to buy back the preferred shares (exit the investment) before the ultimate liquidity event.
o Conversion Rights – These rights give a class of preferred equity the ability to convert their shares into common stock at a specified conversion rate. While most conversion rates are 1:1 (one share of preferred stock is exchangeable into one share of common), we sometimes see different conversions rates such as 1:2 (one share of preferred stock is exchangeable into two shares of common). Frequently, preferred shares are subject to mandatory conversion (they must be exchanged for common shares) if the company proceeds with an IPO.
o Anti-dilution Rights – These rights give a class of preferred equity the ability to adjust liquidation and conversion rights so that dilution is either reduced or avoided due to the issuance of new shares.
o Registration Rights – These rights give a class of preferred equity the ability to compel the company to use its best efforts to proceed with an IPO (or secondary offering).
o Voting Rights, Drag-Along Rights, Protective Provisions, and Veto Rights. These rights give a class of preferred equity disproportionate voting or veto power over the company, or the right to compel other equity classes to vote a particular way.
o Board Composition Rights. These rights give a class of preferred equity disproportionate power to designate specific board members, or to control the board.
o Management and Information Rights. These rights give a class of preferred equity access to pre-specified information such as financial reports, company plans, and the right to attend and observe board meetings.
o Participation Rights (Future Financings). These rights give a class of preferred equity the right to purchase a portion of any future equity financing so that the original ownership percentage is maintained.
In subsequent blogs, I will describe how these provisions typically play out as a venture-capital backed company proceeds with its “exit” either through an Initial Public Offering (IPO) or a sale or wind-up the business. These provisions have a big impact on all classes of equity at exit, in that they determine how much of the value of the company is paid out to each shareholder.
 This quote and the ensuing discussion are adapted from the AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation, Appendix H.
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Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.
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